dies-irae/iStock via Getty Images

dies-irae/iStock via Getty Images

Last week's rally, while long overdue, will probably face challenges moving forward, especially if it came on the notion that the Fed may pause come September. What may have been overlooked is that Raphael Bostic, the Fed governor that suggested a September pause may make sense, is a non-voting member of the FOMC.

So while he may have a valid point, it doesn't carry the same weight as when a voting FOMC member like Chris Waller says he supports raising rates by 50 bps for the next several meetings and wants to see rates climbing above neutral by year-end.

In the past, the FOMC's most significant issue was that inflation was too low, and so when the economy slowed, it was in the Fed's interest to have an easy monetary policy. But that's not the case right now. The Fed is trying to slow growth and weaken demand so that supply and demand levels come back into balance. Investors have grown so used to the Fed caving in every time growth showed signs of slipping. It's an automatic reflex to believe a Fed pivot is coming.

But this time is different. Inflation is a serious problem. So this idea that the Fed will pause anytime soon is not likely to happen even if second quarter real GDP growth is negative. The Fed almost brushed aside the weak first quarter GDP print noting it was driven by categories of spending that had often been volatile in the past. Instead, they focused on the strength in private domestic final demand, the labor market, and industrial production and saw that as providing a more accurate picture of the economy. It creates a risk for the markets. Suppose the Fed focuses only on parts of the economy it gauges healthy? Then it seems quite possible that a second quarter decline in real GDP will not be enough to slow the Fed if inflation remains exceptionally high.

It may sound ridiculous that the equity market has it wrong on the Fed rate hiking cycle. But look at the parts of the markets that actually price future Fed rate hikes. The Fed Fund futures and Eurodollar futures saw no material change for rate hikes last week. Interestingly, since last week, Fed Futures are pricing in higher rates and show no signs of a pause come September as of today.

Eurodollar futures show that same relationship, with no pause in hikes in the near term, which can only make someone wonder what the equity market was thinking about? Or perhaps that other factors were at play at the end of last week contributing to the big rally and that the September pause was a story just made to fit because there was nothing else to explain the rally.

The rally may have been due to a lack of liquidity more than anything else. Data from the CME shows that liquidity in the S&P 500 e-mini futures deteriorated during the last few days of last week. The top of the book for the futures contract dropped dramatically and stood near the recent lows. The decline in book depth is odd because usually the data shows that the depth of books increases when the S&P 500 is rising.

Additionally, we see that the bid-ask spread widened dramatically last week. The spread was even wider than where it was during May lows. Again, rallies in the market typically see the spread between the bid and the ask narrow, not grow wider.

That lack of liquidity in the market tells us that the market rally did not come on healthy grounds. The rally was due to a lack of market participants.

Additionally, there was a sharp contraction in implied volatility, as noted by the sharp decline in the VIX index. The falling implied volatility levels and thin top-of-book and bid-ask spread helped to fuel the equity market rally. This means much of the gains were made of smoke and mirrors and not due to some sudden revelation from the Fed minutes or some idea that the Fed was going to pause come September because a non-voting member suggested it.

Rising market participants and more hawkish rhetoric from Fed governors should work to push stocks lower again, giving back much of the recent gains.

Investing today is more complex than ever. With stocks rising and falling on very little news while doing the opposite of what seems logical. Reading the Markets helps readers cut through all the noise delivering stock ideas and market updates, looking for opportunities.

We use a repeated and detailed process of watching the fundamental trends, technical charts, and options trading data. The process helps isolate and determine where a stock, sector, or market may be heading over various time frames.

To Find Out More Visit Our Home Page

This article was written by

Mott Capital Management writes short-to-medium-term focused articles on where stocks may go. We do not write articles on investing for the long-term. In a typical article, we will tell readers where Mike thinks a stock may go over a short period of time. This allows readers to understand why a stock may be rising or falling based on an analysis of fundamental, technical, and options trading activity. 

We do not trade stocks for compliance purposes and to provide our readers with an unbiased opinion. Mike is a long-term growth investor and discloses if he holds a position in his long-only portfolio. 

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Charts used with the permission of Bloomberg Finance L.P. This report contains independent commentary to be used for informational and educational purposes only. Michael Kramer is a member and investment adviser representative with Mott Capital Management. Mr. Kramer is not affiliated with this company and does not serve on the board of any related company that issued this stock. All opinions and analyses presented by Michael Kramer in this analysis or market report are solely Michael Kramer's views. Readers should not treat any opinion, viewpoint, or prediction expressed by Michael Kramer as a specific solicitation or recommendation to buy or sell a particular security or follow a particular strategy. Michael Kramer's analyses are based upon information and independent research that he considers reliable, but neither Michael Kramer nor Mott Capital Management guarantees its completeness or accuracy, and it should not be relied upon as such. Michael Kramer is not under any obligation to update or correct any information presented in his analyses. Mr. Kramer's statements, guidance, and opinions are subject to change without notice. Past performance is not indicative of future results. Neither Michael Kramer nor Mott Capital Management guarantees any specific outcome or profit. You should be aware of the real risk of loss in following any strategy or investment commentary presented in this analysis. Strategies or investments discussed may fluctuate in price or value. Investments or strategies mentioned in this analysis may not be suitable for you. This material does not consider your particular investment objectives, financial situation, or needs and is not intended as a recommendation appropriate for you. You must make an independent decision regarding investments or strategies in this analysis. Before acting on information in this analysis, you should consider whether it is suitable for your circumstances and strongly consider seeking advice from your own financial or investment adviser to determine the suitability of any investment.